What is the Capital Intensity Ratio?
The Capital Intensity Ratio is a method to measure the reliance on asset purchases by a company to sustain a specified level of growth.
Table of Contents
- How to Calculate Capital Intensity Ratio
- What is a Good Capital Intensity Ratio?
- Capital Intensity Ratio Formula
- Capital Intensity Ratio Calculator
- Capital Intensity Ratio Calculation Example
- Capital Intensity Ratio vs. Asset Turnover: What is the Difference?
- How to Analyze Capital Intensity by Industry
- What are Examples of High vs. Low Capital Intensity Sectors?
- Can Capital Intensity Function as a Barrier to Entry?
How to Calculate Capital Intensity Ratio
Capital-intensive industries are characterized by substantial spending requirements on fixed assets relative to total revenue.
If a company is described as “capital intensive,” its growth is implied to require substantial capital investments, while “non-capital-intensive” companies require less spending to create the same amount of revenue.
Capital intensity measures the amount of spending on assets necessary to support a certain level of revenue.
To illustrate the concept in the form of a question, “How much capital is needed to generate $1.00 of revenue?”
Common examples of capital assets can be found below:
- Equipment
- Property
- Buildings
- Land
- Heavy Machinery
- Vehicles
Companies with significant fixed asset purchases are considered more capital intensive, i.e. requiring consistently high capital expenditures (Capex) as a percentage of revenue.
What is a Good Capital Intensity Ratio?
Capital intensity is a key driver of corporate valuation, because numerous variables are impacted, namely capital expenditures (Capex), depreciation, and net working capital (NWC).
Capex is the purchase of long-term fixed assets, i.e. property, plant & equipment (PP&E), while depreciation is the allocation of the expenditure across the useful life assumption of the fixed asset.
Net working capital (NWC), the other type of reinvestment besides Capex, determines the amount of cash tied up in day-to-day operations.
- Positive Change in NWC → Less Free Cash Flow (FCF)
- Negative Change in NWC → More Free Cash Flow (FCF)
Why? An increase in an operating NWC asset (e.g. accounts receivable, inventories) and a decrease in an operating NWC liability (e.g. accounts payable, accrued expenses) reduce free cash flows (FCFs).
On the other hand, a decrease in an operating NWC asset and an increase in an operating NWC liability causes free cash flows (FCFs) to rise.
Capital Intensity Ratio Formula
One method to gauge a company’s capital intensity is called the “capital intensity ratio.”
Simply put, the capital intensity ratio is the amount of spending required per dollar of revenue generated.
The formula for calculating the capital intensity ratio consists of dividing the average total assets of a company by its revenue in the corresponding period.